by Michael Roh
Abstract
Emissions trading schemes, or cap-and-trade, provide a market-friendly approach for countries to reduce their CO2 emissions. Cap-and-trade works by quantifying the CO2 itself into permits, and then setting a limit, or cap, on emissions by reducing the amount of permits over time. The permits are tradable, allowing for supply and demand forces to create a market, where countries or firms that exceed their emissions must purchase more permits or pay heavy fines, while those that reduce emissions can profit from unused permits, and an overall reduction in emissions is ensured. Since the Kyoto Protocol, cap-and-trade has been encouraged as a strategy to meet emissions reduction targets, and many countries have already ratified the Paris Agreement, the aspirant successor of the Kyoto Protocol. As the Paris Agreement is well underway to entering into force, regions and countries have already implemented cap-and-trade or are in their planning phases. Identifying the features and limitations of existing emissions trading schemes could serve as a blueprint for countries considering emissions trading to consider the most effective strategy. This paper will begin with a short history of cap-and-trade, and an overview of noteworthy emissions trading schemes, including the largest, and most well-known emissions trading scheme, the European Union Emissions Trading Scheme (EU ETS). Though cap-and-trade is not without its flaws, this paper concludes that it can still be effective, and why it is superior to alternative options like a carbon tax.
Key words: emissions trading; cap and trade; climate change; UNFCCC; Paris Agreement; Kyoto Protocol; grandfathering
Scientists say September 2016 will be remembered in history as the month when global CO2 levels failed to drop below 400 ppm (parts per million), and that CO2 levels are not likely to recover in our lifetimes.[1] To understand the significance of passing the 400 ppm threshold, note that CO2 levels prior to the Industrial Revolution were around 280 ppm, and scientists estimate the last time CO2 levels passed 400 ppm was roughly 4.5 million years ago.[2] Moreover, recent data reveals that July 2016 was the hottest month on record since global temperatures have been recorded.[3] Policymakers are slowly coming to realize how destructive, and costly, the consequences of climate change will be. Addressing climate change is seen as a collective action problem, since actors believe the costs are unevenly distributed. But they fail to account for spillover costs. Policymakers in the U.S. and Europe struggle to accept refugees today, but eroding coastlines, disappearing islands, and natural disasters will flood borders with populations displaced by more frequent and destructive natural disasters. For a country’s economy, a supply shortage caused by a hurricane or flood could affect production in a country like China and India, raising prices for consumers in the West. Food supply security is another major concern, as droughts will certainly affect agricultural production around the world.[4] Scientists agree that these concerns will be quickly realized if global temperatures exceed 2 degrees Celsius above pre-industrial levels. At the 21st Conference of the Parties (COP21) to the United Nations Framework Convention on Climate Change (UNFCCC), countries came together to sign the Paris Agreement, which adopted this goal for limiting global temperatures to below 2 degrees Celsius above pre-industrial levels. Countries submit Nationally Determined Contributions, to curb national emissions, and are encouraged to adopt carbon pricing to meet these goals, though cap-and-trade is not endorsed over other carbon pricing methods, like carbon taxes. Currently there are about 40 national and 23 subnational governments with carbon pricing mechanisms.
This paper seeks to uncover the features and various issues affecting existing cap-and-trade programs, and determine whether cap-and-trade is the most effective strategy to reduce emissions. Since the European Union Emissions Trading Scheme (EU ETS) is both the world’s first and currently the largest ETS, and is looked to as a model for other ETSs, it is the main program referenced in this paper. The structure of the paper begins with a brief explanation of how cap-and-trade works, followed by a brief history of the international emissions reduction agreements. The next section will discuss criticisms and flaws in current ETSs. The paper rounds out with a brief comparison between cap-and-trade and carbon taxes, and a few words on China’s national ETS in development.
How cap-and-trade works
In an ideal situation, a carbon market is created, where a regulatory authority establishes a cap on emissions, ensuring a reduction in emissions. How the permits are traded is then left up to supply and demand forces. If a polluting firm wishes to pollute more, it can simply purchase more permits, whereas if it pollutes less, it can profit from selling excess permits. By placing a value on carbon emissions, fundamentally a market is created, and a reduction in carbon emissions is ensured as the cap is reduced over time. Cap-and-trade has three components: a regulatory authority (to set a cap), permits (which are distributed or auctioned off), and a system to allow actors to trade permits.[5] A supply and demand system allows firms emitting low emissions to sell extra emissions to firms emitting greater amounts. These firms then work with what is essentially a carbon budget.[6]
Cap-and-trade is an attractive strategy because it provides flexibility to firms. Firms can decide for themselves whether to sell extra permits, incentivized by profit, or to purchase more permits if they find they can not reduce their emissions. While firms can trade allowances with eachother, the regulatory body (usually the government) can guarantee that overall aggregate emissions will be reduced, subject to externalities. Moreover, the revenue generated from auctioned permits can be used to invest in green energy.
Before the Paris Agreement, the Kyoto Protocol was the first international treaty to discuss greenhouse gas emissions reductions. Adopted in 1997 in Kyoto, Japan, but entered into force since 2005, the Kyoto Protocol commits the parties to the agreement to reduce emissions with binding targets. The structure of the Kyoto Protocol is built upon not only binding commitments to reduce emissions for developed countries, but flexible market mechanisms. Specifically, in addition to reducing emissions domestically, countries can use these market mechanisms to utilize the most cost-effective approach. Therefore, the Kyoto Protocol places less emphasis on where the emissions are reduced, but just that there is an overall reduction. Benefits to this include increased investments into developing countries’ green projects, and inclusion of the private sector.[7]
The UNFCCC divides the international system into three groups with different commitments for each group. Annex I Parties includes OECD[8] countries and countries with economies in transition, including former Soviet countries. Annex II Parties includes OECD countries from Annex I, who are required to provide financial assistance to assist developing countries reduce emissions and transfer green technologies. Non-Annex Parties are developing countries, countries vulnerable to negative effects of climate change, both economically (in terms of fossil fuel producer states concerned about security of supply) and environmentally (in terms of states vulnerable to sea levels and drought concerned about survival).[9] The separate designations and commitments complicate matters, as many countries believe this tier system is unfair. This issue of grandfathering will be discussed later.
Cap-and-trade programs: current and in development
http://www.motherjones.com/environment/2015/02/cap-and-trade-countries
European Union Emissions Trading System (EU ETS)
Covering roughly 45% of the EU’s greenhouse gas emissions, the European Union Emissions Trading System entails 11,000 power stations and manufacturing plants amongst the 28 EU member states, in addition to non-member states Iceland, Liechtenstein, and Norway, making it the largest emissions trading scheme in the world. In the EU ETS, the EU is the regulatory authority that sets the cap and distributes tradable emission allowances.[10] Companies are then provided with some flexibility to curb emissions cost-effectively, as the allowances are used as a form of currency. Each allowance allows the right to emit one tonne of CO2. If companies exceed emissions over the allowances they submit, they are imposed with heavy fines. To avoid this matter, companies can purchase allowances from other companies or purchase emissions trading schemes outside the EU. On the other hand, surplus allowances can be sold for profit. This creates an incentive for companies to reduce their emissions, while also incentivizing investment into cleaner technology. The EU ETS covers energy-intensive industries, as well as the power and heat generation sector, and airline emissions.[11] Within these sectors and industries include power stations, oil refineries, coke ovens, iron and steel plants, cement clinker, glass, lime, bricks, ceramics, pulp, paper and board, aluminum petrochemicals, and commercial aviation. The program covers 45% of the EU’s GHG emissions. Now in the third phase of the program (2013-2020), the cap decreases the quantity of allowances by 1.74%, with the cap in 2013 set at 2,084,301,856 allowances. Phase 3 is also characterized by auctioning over free allocation, which the EU says is how transparency and non-discrimination can be ensured. [12]
Cap-and-Trade in the U.S.
Regional Greenhouse Gas Initiative (RGGI). The Regional Greenhouse Gas Initiative was the first cap-and-trade system in the United States, which covered the Northeast region, including New York. Using three-year control periods, companies must submit the allowances every three years. Using auctioning to allocate allowances, the funds generated from the auctions are then invested into programs like energy efficiency and renewable energy.[13] The program’s goal was to contain emissions at 2009 levels from 2009-2014, with the goal of reducing carbon emissions by 2.5% annually, to eventually come to a reduction of 10% by 2018.[14]
The United States’ Regional Greenhouse Gas Initiative, being the first emissions trading program in a country, whose status as a major fossil fuel consumer and emissions emitter that has previously opposed the Kyoto Protocol, deserves particular attention. The program only covers large electricity generators, and the money raised from allowances, which is almost all auctioned, go to their respective states’ governments, to then be invested into renewable energy and energy efficiency projects. The program is unique for two reasons. First, there is a floor price in allowance auctions. The ability to remove surplus options, preventing prices from falling too drastically, gives the program some influence for how the market operates, avoiding a flood of permits. Second, the program has initiated a substantial transition from coal to natural gas.[15] Natural gas, though still a fossil fuel, is a significantly cleaner fuel to burn than coal. Therefore, this program’s success can be measured by its ability to alter the region’s energy consumption mix.
California Cap-and-Trade. California’s ETS was adopted in 2011 as part of the Global Warming Solutions Act of 2006.[16] The program covers electricity generation, suppliers of natural gas and blended fuels, refineries, cement, glass, iron and steel, etc. These energy-intensive sources are part of the program, including sources whose annual emissions exceed 25,000 metric tonnes of CO2. California’s ETS is unique because it sets both a price ceiling and floor, keeping the price from fluctuating too wildly.[17] California’s ETS utilizes both auctioning and free allocation. The first year generated 525 million USD in revenue from auctioning, and 29 million allowance permits were auctioned. California’s ETS is unique because profits generated from auctions must be invested into efforts to improve air quality. At least a quarter of the profits must go to disadvantaged communities that suffer most from air pollution. The California ETS is linked with one other ETS, in Quebec, while other schemes in Canada are in the process of being linked to California’s ETS.[18]
Republic of Korea Emissions Trading Scheme (KETS)
Launched in 2015 as the first emissions trading scheme in Asia, the program is also the world’s second largest ETS, after the EU ETS. The KETS covers two-thirds of the country’s total emissions. The program’s existence is significant, as South Korea is the OECD’s fastest-growing GHG emitter. With the goal of a 22% reduction below 2012 emission levels by 2030, the program covers 23 industries, including steel, cement, petro-chemicals, refineries, power generation, buildings, waste, and aviation. Within these industries, 525 companies, including five airlines, are included within this scheme. Like the EU ETS, the program is in three phases: Phase 1 (2015-2017), Phase 2 (2018-2020), and Phase 3 (2021-2025). Phase 1 is characterized with no auctioning, and companies are allocated free allowances, according to the base year of 2011-2013. Phase 2 introduces 3% auctioning, while Phase 3 requires at least 10% auctioning.[19]
The South Korean ETS has only been introduced in 2015. Therefore, it is too early to assess its effectiveness and to identify areas needing adjustment. However, its status as the first national program in Asia has implications for the region, and the sheer size of the program being second after the EU’s has implications beyond the region. The program also has the backing of the EU, when in August 2016, it was announced the EU would support the implementation and technology of the KETS under a three-year project, worth 3.5 million euros, funded by both parties.[20] This could provide an opportunity for linking, where firms can purchase or sell allowance permits to firms in another ETS in another jurisdiction.
The success of this program will set a precedent for its neighbors and for other countries that could look to this country that emits a substantial amount of fossil fuel emissions as an example. South Korea’s status as an import-dependent country with a very diversified energy mix will make the country an interesting case study for further analysis.
China’s National Emission Trading Scheme
During a visit to Washington, at the U.S.-China Joint Presidential Statement on Climate Change, President Xi Jinping announced that China will begin implementing a national emissions trading scheme beginning in 2017, which will cover such energy-intensive industries as iron, steel, power generation, chemicals, building materials, paper, and nonferrous metals.[21] China’s eagerness to address China’s air pollution is rational. As a result of the energy-intensive industries that drove China’s economy, China sits in a paradoxical position as both the world’s largest carbon polluter and largest investor in renewable energy.[22] Beijing’s mayor himself admitted that his city is “unliveable.”[23] And the data proves him right. A recent University of California, Berkeley study estimates that air pollution kills about 4,000 people in China a day, due in large part to China’s reliance on burning coal for heating.[24] The situation is dire for a city that is home to an estimated 21 million residents, almost the population of Australia.[25] Therefore, China is serious about tackling its air pollution problem.
There are currently seven pilot ETSs in Beijing, Chongqing, Guangdong, Hubei, Shanghai, Shenzhen, and Tianjin, and these programs will be merged into a national ETS in 2017. Firms emitting more than 5,000 tCO2e[26] must participate in the national ETS.[27] China’s implementation of its ETS is a major victory for environmental activists. Once implemented, roughly half of global GHG emissions will be generated in countries or firms with some form of carbon pricing. For Beijing’s policymakers, environmental concerns once took a backseat to economic progress and industrialization. But the current problems with air pollution can no longer be ignored. Outlooks on the potential for China’s national ETS looks optimistic, given that China has a reputation for following through with decisions, quickly and efficiently, which is exactly how climate change needs to be addressed. China has another key advantage, for not being first. The existing ETSs, particularly the EU ETS, can serve as a blueprint for China to avoid the same obstacles.
Criticisms of cap-and-trade
Less than stellar results
The EU ETS has come under criticism for the scale of its success. The European Commission website states that under the first commitment period (2008-2012) of the Kyoto Protocol, where states committed to reducing emissions to 5% below 1990 levels, the EU exceeded their commitment, with an 8% reduction as a whole. This can be seen as an overachievement, according to the EC, considering that the EU-15 achieved a reduction of 19% (including international credits and carbon sinks), and 11.7% domestically.[28] But critics claim the targets don’t go far enough. To offer a comparison, in the first Kyoto period of 2008-2012, the EU achieved the same emissions reductions as the U.S., despite the U.S. lacking a national emissions scheme.[29] Therefore, it could be argued that the EU would have achieved the same results without the EU ETS. Much of the blame, however, can be traced to a surplus in permits, which is the EU’s own misdoing.
Corruption
Additional criticisms involve accusations of permit fraud in the millions, in addition to claims that high emitting companies receive huge windfall profits through free permits, and the program is hindering investment into renewables and low-carbon technology, as the carbon price fluctuates.[30] The EU ETS’s credibility has been debated, when in 2011, an estimated 50 million euros, or 73 million USD of allowances from Eastern European registries were hacked and transferred into the open market. An incident in the Czech Republic used a bomb threat to evacuate a registry building.[31] Another incident involved traders manipulating tax laws in different countries to fraud governments of over 1 billion euros.[32]
In 2006, India was outed by a Wikileaks revelation for its CDM[33] projects that should not have been certified because they did not reduce emissions for the developing countries beyond those that would have been achieved without foreign investment, meaning that millions of tonnes of CO2 reductions could be falsified.[34]
Grandfathering: Developed and developing countries disagree on what is fair
Grandfathering refers to the practice of determining future emissions allowances based on prior emissions. Therefore, grandfathering allows actors to emit the same percentage of emissions as they have emitted in past years.[36] In terms of state actors, grandfathering applies to the existing emission level of each country, whereby the reductions must then be proportional to the country’s history of emissions.[37] Both the Kyoto Protocol and the EU ETS use forms of grandfathering.
Developed countries defend the status quo, since energy consumption is crucial to their economic activities. Current lifestyles, economic endeavors, technological projects, etc. that are dependent on fossil fuel consumption in the industrialized world are necessary and unable to adjust so abruptly. It’s debatable whether the developed world would face such a destructive adjustment. But people in developed countries must come to terms with the understanding that current consumption patterns cannot continue as they do today.
Developing countries argue that the atmosphere is a common resource, whereby one actor’s actions affect everyone on the planet.[38] Therefore, since carbon emissions accelerate global warming, a universal problem requiring collective action, there is no justification for one actor to have more claim to it than another.
But there can also be a compromise. Grandfathering can be applied in different intensities. Strong grandfathering simply hands out free allowances to previous emitters, whereas moderate grandfathering considers other factors, while still considering prior emissions in the decision-making process.[39] Moderate grandfathering characterizes the current international agreement, the Kyoto Protocol, which does not only consider prior emissions. The Kyoto Protocol places more burden on developed countries, principled on “common but differentiated responsibilities.”2 The EU ETS, also exhibits moderate grandfathering.
Overallocation of permits and price volatility
Perhaps the most compelling criticism of the EU ETS is the over allocation of permits, which created a surplus, particularly to the industrial sector. The volatility of the permit prices do little to incentivize companies to reduce emissions, when there is a surplus of permits, with an estimate there were 400 million tons worth of surplus permits in Phase II of the EU ETS.[40] This also influences the momentum for investment into cleaner technology. The EU ETS has also been criticized for not making any serious impact on low-carbon technological innovation.[41]
The EU ETS’s market characteristics make it susceptible to economic crises and instability, and prone to manipulation by financial actors. In 2008 and 2009, with the global financial crisis, demand for the allowances fell. This prompted companies to sell off large amounts of permits to quickly raise funds. This subsequently triggered extremely low carbon prices, negatively affecting investment into clean energy projects in developing countries.[42]
The prices of allowances are subject to volatility in some cap-and-trade programs. In the EU ETS’s first phase, allowance prices fell significantly. In 2006, Phase 1 permit prices dropped from 31.65 euros in April to 11.95 euros in May. Price volatility is a problem for investment, as it creates uncertainty. Price volatility is also an issue when it comes to linking ETSs. If the price of an allowance is too steep, firms from other jurisdictions will be unwilling to purchase a permit if it is more profitable to just pollute. Establishing price ceilings and floors can help mitigate this problem.
‘Cap and Trade’ limits the potential for more
Emissions trading schemes have also been criticized for its approach, that this environmental problem is now being seen as an economic struggle. Actors are thus too concerned with “prices, sale, purchase, registration, transfer and return of emission allowances and have thereby lost sight of the ecological purpose of the overall enterprise.”[43] Winter acknowledges that in some ways it is an elegant approach, highlighting the issue of scarcity, and diminishing social costs. But actually it creates another problem, introducing a political negotiation process, which is contextualized by calculations of costs and states’ resilience.
The nature of cap-and-trade plays into the rationale of a maximum threshold. The maximum threshold will always be viewed as exploitable. The economics of cap and trade, where allowances are valued, induces actors to either use the allowance or sell it. Any other action is seen as economically irrational.[44] Therefore, a state or actor will always use or sell the allowances. Therein lies the problem, where no state or company would hold emissions allowances, since there is no incentive to do so.
What about a carbon tax?
Carbon taxes, thought not as prevalent as cap-and-trade, is a popular strategy to reduce emissions. A carbon tax assigns a price on carbon itself, setting a tax rate on carbon emissions. It differs from emissions trading schemes in that a reduction in emissions is not ensured. For this reason, a carbon tax delivers more uncertainty. But both strategies share in common the ability to generate government revenue. How this money is spent is key, as ideally they would be invested into green programs, like energy efficiency and renewable energy projects. While carbon taxes provide less predictable emissions reductions, they do offer stable carbon prices, allowing energy producers and investors to make more certain decisions, without having to negotiate the unpredictability of costs.[45] Furthermore, cap-and-trade does not encourage aggregate emissions reduction beyond the target, as firms with excess allowances will always sell them to make a profit. Nevertheless, cap-and-trade is the more popular option of carbon pricing, and since cap-and-trade, in practice, guarantees a reduction in emissions, the certainty of reaching this goal makes cap-and-trade slightly more superior. Any shortcomings of cap-and-trade are design flaws, and these could be refined to make the strategy more effective.
Table 1.
| Cap-and-trade | Carbon tax | |
| Emissions | Government sets a cap | Market determines volume of emissions |
| Price | Market determines price | Government sets a price |
Conclusions
Emissions trading schemes are gaining traction as a way for countries to reduce their GHG emissions, in light of recent, and more ambitious, commitments in international climate change agreements and the growing threat of climate change. A few emissions trading schemes exist on the local, national, and subnational level. The largest ETS, the EU ETS, is largely viewed as a model for others to imitate. However, the EU ETS, being the first, experienced design issues. Other ETSs have also encountered problems but have been able to come up with solutions. Criticisms of cap-and-trade programs include unsubstantial reductions, corruption issues, allowance permit surpluses, poor investment climate due to price volatility, and the Annex designations, which some countries deem unfair. Still, despite cap-and-trade drawbacks, they are mainly due to design issues, which have a number of solutions. Cap-and-trade is still a better alternative to a carbon tax, since, if a reduction in emissions is the main goal, then cap-and-trade is better able to achieve this goal in certainty. There is an optimistic outlook for China’s anticipated national ETS, and China should take a cue from existing ETSs to avoid the same problems.
Lastly, cap-and-trade is just one mechanism used to reduce emissions, which is a short sighted goal. Mitigating climate change necessitates many approaches, and investment into renewable energy technology, which can be a component of ETSs, in addition to more cap-and-trade programs could accelerate these efforts.
Michael Roh is an MA candidate in Energy Politics at the European University at St. Petersburg and Assistant Editor for the ENERPO Journal. Michael has a BA in Political Science from the City University of New York, Hunter College.
Address for correspondence: mike.s.roh@gmail.com
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[26] Tonnes of carbon dioxide equivalent
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